What do I do with excess capital? Pay off the mortgage or invest in Mr. Market. I have heard many arguments to this question. Why pay on a 5% (or less) loan when I am making 10+ % in this bull market? Seems like the choice should be clear, but its not! When I look amortization schedules, I notice the interest is front-loaded in the loans, meaning the first few years it seems like all of my payments are pure interest....
If my payment is 550 for the month and 400 went to cover the interest, then that 5% loan I signed up for seems to me like a 72% interest loan...
When I was driving home from work, I listened to John Pollock on the radio (financial tax strategy specialist). He discussed a concept called "Cash Flow Equivalent Return," which I thought was brilliant. To put this idea in words, he made an example:
"Let’s imagine a mortgage with $100,000 in principal, and a $1000 monthly
payment. If I won $100,000 in the lottery, and paid off the house, I’d
save $1000 each month. The big question is this – if I put that
$100,000 in the market instead of paying off the mortgage, what kind of
rate of return would I need in order to get that same $1000 per month
benefit in my cash flow? Said another way, what’s the Cash Flow
Equivalent Return that I need to break even? I’d need to make $12,000 a
year from my $100,000, a 12% return."
The example above highlights the importance of paying off debts, which is something I have been working on diligently. In my personal case, my rental income will more than cover my families expenses if I was debt free, so this also catalyzes my debt repayment efforts!
A personal blog about my investing strategy and financial health. Will simple investing principles take a kid who starts out with nothing and lead him to financial independence? Follow me on my adventure and see what happens.
Good point to compare a reduction in mortgage in terms of yield and return from investments.
ReplyDeleteI go back and forth with this myself.
Additionally is the amount of money saved in interest. I think I calculated that if I pay $65k extra I will prevent $63k of interest (total payments of $186k left with no extra vs $122k left with normal payments + extra). Thats a 100% return. Roughly 11% return a year I would need to do in the markets to beat that.
Problem is.... paying off the loan early is GUARANTEED. Not including the peace of mind in reducing your monthly bills by that much. A lot to be said for that.
I go back and forth with this. My plan after I catch up my DG portfolio is to aggressively start paying off the condo rental to free up $1000/mo in cash. One thing to remember though is that your real estate income is taxed at normal rates while qualified dividends/long-term capital gains are taxed at much lower rates depending on your tax bracket. My long-term plan is to be 50/50 invested in real estate / equities.
ReplyDeleteYes its important to keep the balance, I am comfortably in the lower tax bracket so my financial decisions would definitely differ from most. When my student loan and smallest rental is paid off I plan on going with the 50/50 balance.
ReplyDeleteThank you for sharing this valuable information!
ReplyDeletego to market plan